Published: 09/13/2019

Ten years have passed since the end of the 2009 financial crisis. Those ten years also mark the longest bull run in the United States, and as stock prices continue to rise, experts are starting to warn of an impending stock market crash.

But, what are the warning signs of a stock market crash? Economists and analysts put great effort into analysing signs of an impending market downtrend and predicting the time of the next market crash.

Traders can also benefit from understanding the major warning signs of a stock market crash and an economic recession. In this article we’ll cover what a market crash is, what its major warning signs are and how traders can take advantage of it.

What is a Stock Market Crash?

A stock market crash refers to a sudden drop in stock prices across a significant number of industries. While there’s no specific definition of a market crash, analysts and economists agree that stock market indices have to fall in double-digit percentage terms over several days during major crashes.

In general, crashes usually occur in times of prolonged uptrends

Crashes are often influenced by crowd behaviour as much as by underlying fundamental factors. As more and more market participants are closing their long positions and sending prices lower, other participants become afraid to step into the market which accelerates the down-move even more.

Stock market crashes are fuelled by a large number of selling orders at the top of an uptrend which drives stock prices lower. As other market participants begin to realise that prices are falling, they also begin to sell which drives prices even lower. They start either to short-sell the market or close existing buy positions, which puts additional downward pressure on the market.

In general, crashes usually occur in times of prolonged uptrends and economic optimism which increases Price to Earning (P/E) ratios above their long-term averages. Bull runs lure investors to take on margin debt and trade on leverage, which is also a major sign of a stock market crash.

Warning Signs of a Stock Market Crash

Rapid Increase in the Value of Stocks

An obvious sign of an impending stock market crash is a rapid rise in the prices of stocks. Evidence shows that many stocks reach record levels just before a market crash.

Price / Earnings (P/E) ratios rise above their average levels as seemingly everyone is investing in the stock market. Bubbles (extremely inflated stock prices) are especially dangerous as they give rise to panic selling. Bubbles take time to form, but once they burst prices drop sharply and dramatically.

Inverted Yield Curves

Inverted yield curves refer to yield curves that have lower interest rates as their maturity increases. Yield curves are graphical representations of bond returns with similar credit quality but different maturities. Economists usually track yield curves of government bonds with different maturities to assess the risk of a market crash. Take the 2-year and 10-year US government bonds for example.

Economic theory suggests that investors who park their money with longer-term bonds should have higher returns than those who invest in shorter-term bonds. However, when market participants expect a recession or market crash, they will invest in long-term bonds which sends their prices up and yields down. As a result, the 2y-10y yield curve inverts and becomes a sign of a potential market crash.

A rise in Margin Debt

An important sign of a potential stock market crash is a rise in margin debt. When trading on margin, a trader has to allocate only a small amount of his trading capital in order to control a relatively large position size. The concepts of margin and leverage are closely tied together.

For example

When trading with a leverage of 5:1, a trader can open a position five times larger than his initial deposit, i.e. he has to deposit a margin of only 20% of the value of the total position size. A leverage of 20:1 allows a trader to control position sizes that are 20 times larger with a margin of only 5% of the position size.

Trading on margin and leverage magnifies not only a trader’s profits but also their losses, which is why this trading approach is considered risky. When market participants invest in the market using margin and leverage, this means that stocks are bought with a large amount of borrowed money. When investors start to lock in their profits, they have to sell their leveraged positions which puts tremendous downward pressure on stock prices.

The Value of the VIX Index

The VIX is quoted in percentage points and represents the expected range of movement in the S&P 500 index over the next year. If the VIX currently stands at 14.33, this means that the expected movement in the S&P 500 index in the next 12 months is 14.33%, up or down. To get the monthly expected movement, divide the VIX reading by √12. This gives an expected movement of 4.13% over the next 30 days.A rise in the value of the VIX index signals that markets expect increased volatility over the coming year, which is often a sign of an upcoming market crash.

A surge in IPOs

Companies go public when stock prices are high. If there is a large number of new IPOs, there is a high probability that the market has reached its top and that a market crash is coming.

Rise in Interest Rates

Last but not least, when central banks start to hike interest rates, this is often a major sign of an upcoming market crash. When economic conditions are good, central banks hike rates to prevent a rise in inflation and to cool down the economy. Higher interest rates mean that companies and consumers are becoming more reluctant to take on loans and debt, which can slow down economic activity and lead to a recession and market crash.

The chart above shows the Federal Funds rate in blue and economic recessions in grey. Recessions and stock market crashes usually follow after a cycle of rate hikes as economic activity starts to slow down.

Examples of Stock Market Crashes in the Past

There have been numerous stock market crashes in the past as the result of speculative bubbles, over leveraging, debt crises and more. We’ve listed some of the most popular below, starting from the Tulip Mania in the 17th century to the most recent Financial Crisis in 2008-2009.

Tulip Mania (Mid-1630s)

The Dutch Republic, now known as the Netherlands, was home not only to the first formally listed public company which set the path for the establishment of stock exchanges, but also the location of the first recorded speculative bubble.

The Tulip Mania refers to a period during which contracts for tulip bulbs reached extremely high levels and then suddenly collapsed in February 1637. At the time, tulips were recently introduced and soon became a signal of wealth, fashion, and a popular investment asset.

Some bulbs were offered for sale for 4,000 guilders, a price multiple times higher than the average yearly income of many Dutch workers.

While the Tulip Mania didn’t have a direct influence on the prosperity of the wealthy Dutch republic, the term is still used metaphorically to refer to large speculative bubbles where asset prices differ from their intrinsic value to a large extent.

Wall Street Crash (1929)

The Wall Street Crash of 1929-1932 was one of the most dramatic stock market crashes in the United States, followed by the Great Depression which lasted throughout the 1930s.

First signs of the Wall Street Crash can be traced back to the 1920s, which had been a technological golden age with innovations such as the radio, telephone, and automobile.

The stock market began to attract an increasing number of investors who were lured by the high returns and rising stock prices. This was the time when stocks such as General Motors, Radio Corporation of America and Goldman Sachs Trading Corporation rapidly rose in value.

The Dow Jones Industrial Average (DJIA) had risen sixfold in the following eight years, touching 381.2 points on September 3, 1929. The same year, it became clear that the economy was contracting and stock prices began to fall after reaching their high. As investors became increasingly anxious, they began to sell their stocks on October 24, also known as Black Thursday.

The following days, the Dow Jones Industrial Average fell more than 40% as the stock exchange was flooded with sell orders. Telephone lines were clogged, which led to even more panic selling. The stock market started to recover the next few months, only to experience a new dramatic fall in July 1932 when the DJIA lost around 89% of its pre-crisis high.

2008-2009 Financial Crisis

The 2008 financial crisis started with the failure of major financial institutions based in the United States, due to their exposure to subprime loans and credit default swaps.

On September 15, 2008, Lehman Brothers filed for the largest bankruptcy in history, with $639 billion in assets and $619 billion in debt. This eventually triggered a chain of events and resulted in a number of bank failures in Europe and dramatic falls in global stock prices.

In the week from October 6-10, the Dow Jones Industrial Average (DJIA) fell over 1,800 points, or 18%, posting its worst weekly decline ever. In one of the largest financial crisis in human history, the DJIA index dropped 54% over a span of 17 months, measured from its October 9, 2007 high of 14,164.

How Should Traders React?

Financial crisis and stock market crashes are one of the most catastrophic events in the professional life of a trader and investor. Still, they can offer a tremendous amount of volatility and create profitable trading opportunities in certain asset classes and financial instruments. That’s why you need to be prepared for the next stock market crash or economic recession.

The most general advice is to stay at the sidelines during strong market crashes and recessions. Especially longer-term traders and investors should immediately close their positions that have exposure to the equity market or certain risk instruments.

… general advice is to stay at the sidelines during strong market crashes

You want to free up your capital and be able to buy once the market hits the bottom – one of the most lucrative trading opportunities arise when everyone in the market is selling. Eventually, stock prices will rise again once the dust settles.

Traders who want to take advantage of the volatility and keep trading during major crashes should look into safe-havens and short-selling opportunities.

When a bear market begins and the market starts to form consecutive lower lows and lower highs, traders can short-sell financial instruments at the top of lower highs when the downtrend usually resumes its path.

The recent financial crisis of 2008-2009 has also seen certain safe-havens rise in value when stock prices were plummeting.

Traditional safe-havens such as gold are always a good trading decision during market crashes, as are safe-haven currencies like the US dollar, Swiss franc, and Japanese yen. As investors are pulling money out of the stock market, demand for US dollars and other safe-haven currencies rise.

When is the Next Stock Market Crash?

As of the beginning of September 2019, the S&P 500 index which tracks the largest 500 US companies stood just shy of its record-high of 3,028, reached on July 26, 2019. Since the beginning of the year, the S&P 500 index has risen more than 15%, marking a decade of uptrend and the longest bull run in the United States since the 1990s internet boom.

Is the stock market in a speculative bubble that is about to burst? The market is going to crash, that’s simply the nature of the beast. The only question that remains unanswered is “When?”.

Will it be this year? The recent Bank of America Merrill Lynch (BAML) Global Fund Manager Survey revealed some interesting patterns in the fund industry.

Fund managers have been increasing their cash positions to their highest levels since 2011, signalling risk aversion

Balance sheets of many funds show the smallest ratio of stocks vs. bonds since 2008, as managers are lowering their exposure to stocks and equities

Global economic growth forecasts are at record-low levels, partially due to trade tensions between the US and China

The Fed may start to hike rates again as the US economy performs relatively well

With stock prices near record highs, the market could enter into a corrective phase and push prices lower. Nevertheless, it’s hard to predict when a full-sized market crash will happen.

Final Words

Stock market crashes refer to a sudden and dramatic drop in stock prices, spread over numerous industries and sub-industries. A double-digit percentage fall in major stock indices over a few days is usually considered and labeled as a stock market crash.

While anticipating stock market crashes is quite difficult, traders and investors can follow some important warning signs, such as daily changes in worldwide stock indices, the level of margin debt, number of IPOs, the existence of inverted yield curves, the VIX index and whether central banks are in a rate hiking cycle or not.

Stock market crashes can be painful for investors and traders, but hedging your equity exposure with safe-havens can reduce your overall market risk and even provide profitable trading opportunities.

In times of an imminent market crash, consider buying traditional safe havens such as gold, the US dollar, Swiss franc, and Japanese yen, or stay at the sidelines until market conditions start to improve again. Buying at the bottoms of market crashes has proved to be a lucrative deal in the past.

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